An Investment Policy Statement Takes Emotion Off the Table
We all have emotions and biases. Fear and greed are two of the most powerful emotions and are often a foundation endowment’s worst enemies. As investors, we need to be self-aware and recognize how these emotions can impact our investment decision-making. In order to reduce investment risk related to emotions, crafting and implementing an Investment Policy Statement (“IPS”) is an investment committee’s best defense.
Don’t Be an Emotional Investor
Acknowledging the impact of emotions is an important aspect to investing. An investor’s emotions can suppress rational thinking when making investment decisions. The concept of “herd instinct”, or the tendency for people to follow popular trends without their own thoughtful consideration, can be significant in explaining how fear and greed can lead to dramatic rallies and sell-offs of investments. Unchecked emotions can lead investors to make unwise or uninformed decisions:
- Fear – We spend more time and energy fearing the unknown than is rational. Specific to investing, the media “sells” fear through headlines such as “Are stocks in a bubble?” and “Has the bull market run its course?”. Selling begets selling, and all too often, investors following the herd of sellers will exit positions at exactly the time they should be buying.
- Greed – It is human nature to be competitive and want to win. When it comes to investing, investors have a tendency to invest in assets that are “winning” or rising in value. This investing often results in demand outstripping supply and may eventually result in valuation bubbles.
One of the best examples of herding into a bubble in recent years was the cryptocurrency craze of 2017. Bitcoin rose from below $1,000 per coin at the start of 2017 and peaked near $20,000 per coin in December of the same year when holiday conversations revolved around cryptocurrencies and the urgency to get involved for fear of missing out. One year later, Bitcoin closed 2018 at $3,747 per coin.
Ironically, the fear of missing out propels greed. Trying to time the herd’s exit before a bubble bursts is difficult for investors as they try to temper enthusiasm in the moment. A well designed Investment Policy Statement proactively and rationally guides a committee to reduce exposure to assets that may be in bubble territory. This asset rebalancing may remove the opportunity to capture potential valuation upside but, more importantly, it maintains a disciplined process that may manage the risk of greater loss.
Unemotional Investing Starts with an Investment Policy Statement
An Investment Policy Statement removes emotion from the conversation. When an investment committee meets, all members have their own experience and perspectives that shape interpretations of the endowment’s portfolio and performance. Too often, committee members may compare personal investment performance to the endowment’s performance. As an example, Member A’s personal portfolio is up 10%, Member B’s personal portfolio is flat and the endowment is up 5%. Member A may complain the endowment is doing poorly and not taking enough risk while Member B may consider the endowment a “rock star” and want to reduce the risk. A committee meeting may quickly dissolve into an unproductive conversation in this scenario. Comparing one’s personal portfolio to an endowment can be destructive and counter-productive as an endowment’s financial objective and risk profile should be meaningfully different from an individual’s objective. An IPS is the answer to ensure effective meetings and thoughtful decision-making.
A well-constructed IPS should address the following issues at a minimum:
Set realistic portfolio return objectives/targets. What return does the endowment need to generate in order to satisfy spending needs? What benchmark(s) will the endowment establish to measure performance? Does the endowment require a customized benchmark to account for special considerations such as sustainable, responsible, or ethical investing?
Determine various investment classes and asset allocation ranges. Once the return objectives are established, the investment committee needs to determine what types of investments to own. A potential starting point may be determining an appropriate mix between equities, fixed income, and cash. In order to account for economic cycles, a flexible mix of investments with minimum and maximum percentage ranges provides guardrails and mitigates investment risk. Other asset classes such as alternatives, real estate and commodities can be introduced depending on the endowment’s desire for complexity and diversification. An endowment should avoid being in a situation of selling assets during distressed markets, so maintaining an appropriate level (0%-10%) of cash is usually desired.
Identify responsibilities and expectations of stakeholders. Should the board of directors establish an investment committee? If so, what responsibilities does the board delegate to the committee? Is investment decision-making discretionary (advisor makes investment decisions) or non-discretionary (advisor makes recommendations and the committee makes and implements decisions)? How does the committee monitor and evaluate the endowment performance and the investment advisors/managers?
Earlier this year, I was involved in our family foundations IPS review which occurs every three years. Our committee set up a conference call outside our quarterly meetings to focus on this review and take a fresh look at our IPS. A one hour call lasted two hours as we had a thoughtful discussion around investment philosophy and risk tolerance. We came out of the discussion with everyone affirming a conservative “belts and suspenders” approach to managing the endowment – we are willing to temper our upside potential to decrease the downside risk. During our call, we never once talked about current investments or historical endowment performance which was refreshing as these topics tend to be a source of disagreement and dominate committee discussions.
Foundations that invest the time and effort in establishing an IPS give their investment committees discipline and confidence to navigate any economic environment and reduce the risk of emotions negatively impacting decision-making.